Investing in Emerging Market Brazil Has Big BRIC Potential

Emerging markets offer profound promise to investors, but not all emerging markets offer the same opportunities. The emerging-market story that most investors are familiar with is focused on Brazil, Russia, India, and China, better known as the BRICs. The story is, of course, that economic growth in the BRICs is likely to exceed growth in the developed world, so the performance of BRIC funds will outperform developed-economy stock markets. Investors buying into this thesis may be disappointed.

Economic growth is only one determinant of long-term stock market performance. In fact, the historical record shows no correlation between economic growth and long-term stock market returns across countries. My chart below is a scatter plot of the compound annual return of 22 developed and emerging equity markets from 1975 to 2007 versus economic growth in each country over the same time period. The horizontal axis is economic growth, and the vertical axis is equity-market performance. See any pattern here? If economic growth were as important as the emerging-market perma-bull crowd would like you to believe, you would see an upward-sloping pattern to the diamonds on my chart. There is no discernable pattern here. There are more important determinants of equity-market performance than the rate of economic growth.

Some of the more important factors to consider are the valuation of a country’s stock market and currency, as well as its political, economic, and monetary structure. Shareholder rights and the level of corruption are also important factors to evaluate.

Once you recognize that higher economic growth does not necessarily result in greater stock market performance, you can make a sound decision about the outlook for each of the four BRIC funds.

Serious Risks in China

There are serious risks to investment in China. The Chinese are misallocating capital on a massive scale. Certain real estate markets are deep into bubble territory, and you can be sure there’s a fixed-asset investment bubble in the country. This, of course, shouldn’t come as a surprise since the rate of interest in China has been far below the rate of economic growth for over two decades now (see chart). China is also still a command economy—a risk that is greatly underappreciated by the investment community. The business community has also ignored this risk for years but is finally beginning to recognize the dangers of operating in a command economy. According to the American Chamber of Commerce, there is growing concern on the part of U.S. businesses regarding China’s protectionist policies, which favor state-owned enterprises in the country. I’ve long advised against investing directly in China and continue to believe direct investment in China should be avoided.

BRIC Investments in India & Russia

India likely offers more long-term promise than China, but we are talking about the long, long term. The country is the poorest BRIC, and India’s infrastructure is a serious deterrent to economic growth. I see no compelling reason to invest in India today. I have invested in Russia in the past, but am currently avoiding Russian stocks. Russia’s equity markets are largely dominated by energy and other resources companies. I see potential in Russia, but I also see an inflation problem and a corruption problem, and I have concerns about economic diversification and stability. Avoid Russian stocks.

Brazil investments offer a Compelling Opportunity

Brazil offers the most compelling opportunity for a successful, long-term BRIC investment. Brazil’s economy is diversified, it is not export dependent, and it is competitive in manufactured goods. Brazil is the only BRIC nation that is both a stable democracy and at peace with all its neighbors. Brazil does not engage in a mercantilist exchange-rate policy to boost exports. The country has universal state-funded education, health care, and pensions. Brazil is the world’s leading exporter of iron ore, coffee, soy, orange juice, beef, chicken, sugar, and ethanol. Brazil also has 958 million acres of highly productive arable land, with 222 million acres that have yet to be farmed. Brazil generates 73% of its energy needs from hydroelectric power, and it is home to one of the top 10 largest oil reserves in the world, the Tupi field.

Brazil also runs a tight monetary ship. This, of course, has not always been the case, but the country appears to have learned from its mistakes. The fact that Brazil’s central bank recently raised interest rates to tame inflation in an election year is quite telling. Take a position in Market Vectors Brazil Small-Cap (BRF) or iShares MSCI Brazil (EWZ) if you do not yet own one.

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